Monthly Archives: March 2013

Major stock markets are closed today–Japan is the significant exception. In most of the world, it’s for religious reasons; on Wall Street it’s the belief that opening on Good Friday brings a market decline.

A sidebar next to the “Heard on the Street” column of yesterday’s Wall Street Journal highlighted a research study by Profs. Lauren Cohen and Christopher Malloy of Harvard and Prof. Dong Lou of the London School of Economics titled “Playing Favorites…”. I found the study itself on Prof. Cohen’s web page (along with a lot of other neat stuff that I’ll be writing about soon). It’s well worth reading at least the summary at the beginning.

information manipulation

Mssrs. Cohen, Lou and Malloy studied the way in which companies choreograph conference calls by selecting the analysts who are allowed to ask questions. Their finding: companies that routinely call only on the analysts who are the most favorably disposed toward them–as measured by how bullish their official buy/sell recommendations are–may have a temporary positive bounce right after the call. But they end up being significant subsequent stock market underperformers.

how so?

The authors suggest three motivations for companies to engage in this type of information manipulation. It may want only softball questions because (in my words, not necessarily theirs):

–a company may be trying to “smooth” earnings by making more or less arbitrary changes in its accruals for, say, inventories or tax rates, and doesen’t want these devices subjected to scrutiny, or

–a company may have made its earnings guidance only by the skin of its teeth–and maybe even then only by making dubious accounting choices, which they may not want exposed to the light of day, or

–a company may want to present a glowing, somewhat bookkeeping PED-assisted, quarter because it’s going to soon sell new equity and wants the most favorable price.

why do analysts play ball?

After all, it’s embarrassing to be seen as a sycophant.

CL&M point out that the analysts called on may get to fill the holes in their earnings forecast spreadsheets, and therefore improve their future profit forecasts. Colleagues who can only listen to the call may have different holes but can’t get them filled, so their forecasts may gain nothing. In any event, CL&M demonstrate the favored analysts do indeed have better numbers.

As far as “why,” my experience is that the brokers the favored analysts work for garner more investment banking business from the firm in question. Management returns the follow-up calls of the favored analysts faster, so they have better answers for their money management clients. And when the CEO or CFO visits institutional holders of the stock, the softball-tossing analysts most often get to arrange the itinerary. All this means more money for the brokerage houses they work for–and because of this for the analysts themselves.

the best earnings estimates?

How do the CEO’s pets end up with the best earnings estimates? It may be the way CL&M suggest.

I don’t believe it, though. Personally, I think selective disclosure still happens, despite its prohibition by Regulation FD. At the very least, more frequent contact with management gives the favored analyst a greater chance to understand and decipher body language, intonation and word choice–all of which can provide valuable hints about how business is going.

why do these firms subsequently crash and burn?

CL&M observe that the analyst selection behavior is designed to prevent bad news from reaching the market. But there are limits to how long negative information can be suppressed. Eventually the companies have to come clean–if for no other reason than the auditors have arrived. This results in negative earnings revisions and stock underperformance.

Maybe so. Personally, I have a simpler, though non-verifiable view. I think the conference call manipulation stems from–and reveals–a character flaw in a firm’s CEO. The boss doesn’t want to have his ideas questioned and never wants to hear bad news. Because he always shoots the messenger, subordinates hide unpleasant realities until they’re so big they’ve done serious damage to the firm.

one complaint, sort of

The study has a lot of statistics but no names of offending companies. They would be worth knowing. A shrewd investor, however, would keep that information for himself. He’d also thereby avoid a firestorm of protest from egomaniacal CEOs.

Morgan Keegan, now a part of Raymond James, was a regional brokerage firm with a strong fixed income emphasis. It was severely wounded by large losses in fixed income mutual funds during the housing meltdown, and by subsequent SEC legal actions. The regulator accused the firm of misrepresenting the risk character of some mutual fund offerings to potential clients and of systematically mispricing funds over extended periods of time. As part of a settlement, the portfolio manager who ran a number of these funds agreed to a fine of $500,000 and a lifetime ban from the securities industry.

“So, what’s new?” you may ask.

What’s unusual about this case is that late last year the SEC sued the boards of directors of some of these funds for what it says was their failure to ensure that the funds were priced correctly. Although directors are, legally speaking, the highest-ranking officials in any mutual fund and are therefore directly responsible for the conduct of the fund’s officers and staff, the SEC has until now only held the investment professionals and support staffs of wayward funds accountable for their actions–and left the directors alone.

my thoughts

1. The returns cited by the Wall Street Journal for one of these funds in reporting on this case are really ugly. It lost 30% of its value in 2008 vs. a return of +6.8% by the fund’s performance benchmark. In 2008, the fund was down by 73.2% vs. a benchmark return of +4.0%.

2. Fair value pricing–meaning having third-party experts estimate a price for a security if there are no trades for it on a given day–is an important issue. Typically a rogue manager or a rogue firm will want to assign securities a price that’s too high, to disguise a fund’s underperformance.

The problem: shareholders who sense the problem early and cash in their shares get more than their share of the fund assets, leaving loyal/trusting shareholders with a large hole in their fund NAV once the fraud is uncovered.

3. Fair value pricing isn’t a new issue. It was a big problem during the collapse of the junk bond market in the late 1980s. It was also the centerpiece of Eliot Spitzer’s expose of shady practices by international funds in the mid-1990s. Apparently the SEC again called mutual fund boards’ attention to possible fair value pricing issues with funds holding mortgage-backed bonds in 2007.

4. The SEC must think that its warnings were being ignored by mutual fund boards and that it had to make an example of someone.

5. If so, the agency appears to have chosen its target well. Morgan Keegan isn’t a large, deep-pocketed, politically powerful investment banker like Goldman Sachs or Morgan Stanley. The Morgan Keegan name no longer exists. The firm has recently been sold to Raymond James, whose executives presumably have no personal ties with the accused directors and no interest in prolonged or expensive litigation which would only keep any past Morgan Keegan misdeeds in the public eye.

Yes, the directors doubtless have liability insurance against possible lawsuit. But my guess is that the insurer in question may assert that coverage doesn’t extend to instances like this.

This case has the potential to change the way mutual fund directors are selected, what qualifications they should have, how they carry out their duties and how much they’re paid. It’s worth keeping an eye on.

I’ve been watching the career of oilman T. Boone Pickens since I picked up coverage of his Amarillo, Texas-based Mesa Petroleum as a rookie analyst in 1979.

Always a showman, Mr. Pickens was, in my view, at best a middling oilman, but he was a brilliant user of financial engineering. For example, when Mesa had bought a large swath of Gulf Coast drilling rights that turned out not to contain much oil and gas–only enough to recover costs–Pickens borrowed an idea from nineteenth-century steel companies and spun the dud properties off to shareholders in a royalty trust.

Placing them in the hands of income-oriented investors gave them a value they would never have otherwise had. The action spruced up the financial metrics of the slimmed-down Mesa, to boot. And Pickens successfully cast the move as the caring response of a powerful oil company to shareholder needs–which, in a sense, it was.

His latest foray into fund-raising for athletics at his alma mater, Oklahoma State University, however, is a little weird. According to the Wall Street Journal, Pickens and OSU decided to insure the lives of 27 elderly alumni for $10 million each, in a program named “Gift of a Lifetime.” OSU would pay the premiums and be the beneficiary. The idea was apparently that if the participants died faster than the insurance company actuaries figured, OSU athletics could gain up to a quarter-billion dollars.

A fly in the ointment …those old Cowboys refused to die. (Actually, if the WSJ figures are correct, the entire group would have had to pass away within two years for the fundraising effort to have a $250 million “profit.”)

After two years and $33 million in premiums paid, the program ran out of money and allowed the policies to lapse. Then Pickens and OSU sued the insurer, Lincoln National Life, claiming fraud and demanding its premiums back.

The whole odd story came to light when a Federal Appeals court last week upheld the verdict of a lower court in favor of Lincoln.

Over the weekend the EU and IMF came to agreement with the government of Cyprus on the shape that the rescue of Cyprus’ failing banks will take (I wrote about the overall situation late lase week). The banks themselves remain closed, as they have been for ten days.

The highlights, if that’s the right word to use:

–the smaller of the two main Cyprus banks, Bank Laiki, will closed down. It will be separated into a “good” bank, which will contain all insured deposits (those of €100,000 or less), and a “bad” bank, which will contain everything else. Deposits in the former are safe. Deposit and bond holders in the latter will get whatever’s left after the bank’s dud loans are settled. That could well be close to zero–and, in any event, large depositors will have lost access to their funds for a considerable period of time.

–the Bank of Cyprus, the bigger bank, will remain open. This is a face-saving concession insisted upon by the Cyprus government. Uninsured deposits will be used to cover the losses on the bank’s loan book, with uninsired depositors losing as much as 40% of their money.

it’s Cyprus’ best alternative

The country’s recent prosperity is due mostly to the access it allows to the rest of the EU, and its less than diligent attention it pays to the provenance of the bank deposits it accepts.

The rescue injects €10 billion of EU/IMF money into the Cyprus banking system. Cyprus also gets to remain in the EU. Otherwise, it would still have the same large bank loan losses, but be €10 billion poorer and out in the cold.

Some commentators are saying that the losses that uninsured deposits in Cyprus will suffer will undermine confidence in the banks in other EU countries, like Italy or Spain. I don’t think so. The Cyprus story–crazy bank lending, deposits of dubious origin, tax haven–is well-known throughout the EU. If anything, the union was hamstrung in its efforts to bail Cyprus out by how well-known the story is–and, in consequence, how politically unacceptable an outcome where Cyprus escaped very significant hardship would be.

The main result of the Cyprus episode, I think, will be to give the EU a significant push toward unified EU bank regulation.

Before the opening bell this morning on Wall Street, TIF reported 4Q12 (the company’s fiscal year ends in January) results. Sales were up 4% year on year during the quarter, at $1.2 billion. Net earnings were up 1% yoy, at $180 million. That works out to eps of $1.40, vs. the $1.39 reported for 4Q11. But it was $.04 above the brokerage house consensus of $1.36.

For the full year, sales were up 4% at $3.8 billion. Net income was $416 million, down from $465 million in fiscal 2011.

In its earnings release, TIF also gave its first guidance for fiscal 2013. It expects sales to be up by 6%-8% and eps to move roughly in line–but possibly with a touch of positive operating leverage evident later in the year. 1Q13 will be relatively weak (TIF fingers marketing costs and high raw material prices as the culprits), but earnings comparisons will likely improve from then on.

As I’m writing this, shortly after the open, TIF shares are up almost 3% in a market that’s up by about half a percent.

I don’t see why.

my take

TIF is an exceptionally well-managed company with a powerful brand name in the Americas and the Pacific, and in a business, luxury goods, that has strong long-term growth prospects.

This is the first time in five quarters that TIF results have exceeded the Wall Street consensus. That’s a plus, although the “beat” is at least partly due to analysts’ low-balling their estimates after having whiffed four quarters in a row.

Management guidance of 6%-9% eps growth for fiscal 2013 is also a low-ball number, in my view. I think +10% is easily attainable but believing in +15% would be a stretch.

my issue is valuation

I’ve owned the stock in the past but don’t now. Based on management guidance, the stock is trading at 20x year-ahead earnings, which is about as high as the PE has gotten over the past decade.

–Yes, there have been short periods when the multiple has spiked higher, but who wants to count on this happening again.

–Yes, there may be another, say, 5% to count on in the stock as earnings come in better than guidance. But a professional investor should be looking for the potential +30%s and the +50%. There’s just not enough upside here.

–Yes, there’s recurring speculation that some EU luxury conglomerate may buy TIF. But, again, is this enough of an investment thesis? In my view, no. If the stock were trading at 15x earnings, however, it would be a different story.

what catches my eye in the release

TIF still doesn’t have its balance sheet completely back under control. A while ago, when world economic prospects looked brighter, TIF decided to boost its inventories significantly. That was so as not to lose sales for lack of stuff to sell, as well as to support a quickened store expansion plan. …an aggressive, but very sensible strategy.

As global growth started to fade, TIF put on the manufacturing brakes. But at 1/31/13, inventories were still $161 million higher than a year earlier. And debt, net of cash, was up by $176 million. That’s the reason, I think, why TIF bought back no stock during 4Q12, despite the fact the shares spent much of December in the mid-high $50s–vs. TIF’s full-year average buyback price of $66.54.

Comparable store sales in the Pacific, ex Japan and ex currency effects, were +6% for 4Q12. I interpret this figure as saying sales there, which I view as the key factor that could make fiscal 2013 surprisingly good for TIF, have passed their low point. TIF is penciling in a “mid-teens” total sales increase for the region–implying, I think, +10% for comparable store sales. In a better Chinese economy and with clarification of the new government’s view on luxury goods consumption, that figure may be way too low. If there’s one thing TIF bulls should monitor, this is it. If there’s one thing that could change my mind about the stock, this is it.

Cyprus is a Mediterranean island-state with a population of about 1 million and an annual nominal GDP of around US$24 billion (€18 billion). The country joined the EU in 2004. At that time, the union was still in a phase of wanting to be all-inclusive. But even so, perhaps the only member enthusiastic about Cyprus’s entry was Greece, because of the two nations’ close business and ethnic ties. As I understand the situation, it took a Greek threat to blackball other prospective members, like Poland, before Cyprus was allowed to slip in the door. Cyprus joined the eurozone in 2008.

Why the reluctance?

Low tax rates have given Cyprus a long-standing reputation as a tax haven. But after the collapse of the Soviet Union and the subsequent efforts by the nomenklatura in member countries to abscond with the national wealth, Cyprus is thought to have welcomed the cash of all comers, without being overly finicky about the source or legal status of the tidal wave of money it was receiving.

With its entry into the EU, Cyprus began to exert an even greater magnetic attraction for wealthy Russian immigrants seeking citizenship–and the access to the rest of the EU that a Cyprus passport would bring. Deposits by foreigners into banks in Cyprus also ballooned. About 40% of the almost €70 billion in bank deposits the Cyprus banks are thought to hold, are estimated to be from foreigners, most of them Russian.

How did the banks get into trouble?

The influx of cash gave them more money than they knew what to do with. So they lent …crazily. A large chunk of loans went to Greek businesses, and a lot more was “recycled” into Russia and other parts of the old USSR. The banks bought a large helping of Greek government bonds, as well. And they funded a local property bubble.

How bad is the situation?

from Cyprus’s point of view

Because of the way they operate, the banks in Cyprus are gigantic in relation to the size of the country. To get a sense of how big, consider the United States. According to the Federal Reserve, the total of deposits in commercial banks in the US is $9 trillion, give or take, or about 58% of GDP. Deposits in Cyprus banks are almost 4x that country’s GDP.

The bailout of the Cyprus banking system proposed by the European Central Bank and the International Monetary Fund is €17 billion. Of that, €10 billion is supposed to be coming from the EU/IMF. The other €7 billion is supposed to come from Cyprus–an amount that’s almost 40% of GDP. Where can/will Cyprus get its share of the money?

A standard remedy for banks facing default would be to go to their lenders and ask they to take a (huge) haircut on their loans. That’s what Greece ultimately did. But the Cyprus banks are like giant cash machines. They haven’t needed to borrow; they have almost no lenders to share the pain with.

The government could raise taxes–but it would have to be a whopper of an increase to make a dent in the funds needed. And Cyprus’s government finances are already in bad shape.

So the obvious (read: only) source of bailout funds is uninsured customer deposits.

Hence, the plan to “tax” these deposits to get Cyprus’s share of the bailout money–offering equity in the restructured banks in compensation. The way the tax is structured, it seems to hurt ordinary citizens and spare the oligarchs.

from the rest of the EU’s

In the overall scheme of the EU bank rescue, €17 billion is a trivial amount of money. It’s something like a week’s interest expense on aggregate EU government debt. But there’s a principle involved. And there’s a related political issue.

In principle, a country that fails to supervise its banks and mishandles government finances shouldn’t simply be rescued without any contribution of its own. Also, the biggest beneficiaries of any bailout would be what many regard as Russian criminals laundering their money through the Cyprus banks, with Nicosia complicit. Understandably a hard sell throughout the EU–or anywhere else.

where to from here

The banks on Cyprus will be closed until some time next week, as the parties work toward a solution. The main stumbling block sounds like it’s Nicosia’s desire to protect the golden goose of Russian money flow.

Stock market worries have been centered around the possibility of a run on banks in, say, Italy and Spain, if depositors in Cyprus lose part of their principal. Part of the panic was sparked by economic “experts” who are recognizable names and who churned out the initial reports on late weekend’s bailout negotiations. I think these pundits reacted to the headlines without knowing many of the facts. It’s not that I’m an expert on Cyprus–I’m not. But it’s pretty easy to detect when interviewees are talking through their hats.

The worst case solution for Cyprus would be that its major banks fail and the country is forced to leave the EU. Very bad for Cyprus. Almost no one else in the EU would notice. Russian oligarchs wouldn’t be happy.

A run on other EU banks? Unlikely, in my view. The facts in the Cyprus case are very unusual, given the dubious character of its banks. And the pressure on the EU not to simply throw money at the problem and make it go away is coming from ordinary citizens elsewhere in the EU who have their money on deposit locally. They seem to see a big difference between their home country institutions and those on Cyprus. I think they’ll continue to do so.

a wild card

Russia has previously made a bailout loan of €2.5 billion to Cyprus to prop up its banks. Discussions are apparently underway between Moscow and Nicosia for more aid. One plan being would have Cyprus grant Gazprom oil and gas exploration rights in return for, say, taking over one of the big insolvent Cyprus banks.